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Management Information Systems, 13TH ED.
MANAGING THE DIGITAL FIRM
Kenneth C. Laudon ● Jane P. Laudon
continued
Learning Track 1: Capital Budgeting Methods for Information
System Investments
Traditional Capital Budgeting Models
Capital budgeting models are one of several techniques used to measure the value of investing in
long-term capital investment projects. fie process of analyzing and selecting various proposals for
capital expenditures is called capital budgeting. Firms invest in capi tal projects to expand produc-
Six capital budgeting models are used to evaluate capital projects:
◆ fie payback method
◆ fie accounting rate of return on investment (ROI)
◆ fie net present value
◆ fie cost-benefit ratio
◆ fie profitability index
◆ fie internal rate of return (IRR)
Capital budgeting methods rely on measures of cash ows into and out of the firm. Capital proj-
ects generate cash ows into and out of the firm. fie investment cost is an immediate cash outow
caused by the purchase of the capital equipment. In subsequent years, the investment may cause
additional cash outows that will be balanced by cash inows resulting from the investment. Cash
Chapter 14: Managing Projects
Chapter 14 Learning Track 1 2
continued
money. When one has to choose among many complex alternatives, these assumptions are rarely
met in the real world, although they may be approximated. Table 14-1 lists some of the more
TABLE 14-1 Costs and Benefits of Information Systems
COSTS
Hardware
Telecommunications
TANGIBLE BENEFITS (COST SAVINGS)
Increased productivity
Lower operational costs
Increased organizational flexibility
More timely information
More information
Increased organizational learning
Legal requirements attained
Chapter 14 Learning Track 1 3
LIMITATIONS OF FINANCIAL MODELS
computer-supported collaborative work systems. Traditional approaches to valuing information
systems investments tend to assess the profitability of individual systems projects for specific busi-
ness functions. fieses approaches do not adequately address investments in IT infrastructure,
testing new business models, or other enterprise-wide capabilities that could benefit the organiza-
tion as a whole (Ross and Beath, 2002).
equipment and other long-term investments, such as electrical generating facilities and telephone
networks. fiese investments had expected lives of more than 1 year and up to 25 years. However,
information systems differ from manufacturing systems in that their life expectancy is shorter.
fie very high rate of technological change in computer-based information systems means that
most systems are seriously out of date in 5 to 8 years. fie high rate of technological obsolescence
Chapter 14 Learning Track 1 4
continued
Case Example: Capital Budgeting for a New Supply
Chain Management System
Let’s look at how financial models would work in a real-world business scenario. Heartland Stores
is a general merchandise retail chain operating in eight midwestern states. It has five region-
al distribution centers, 377 stores, and about 14,000 different products stocked in each store. fie
company is considering investing in new software and hardware modules to upgrade its existing
supply chain management system to help it better manage the purchase and movement of goods
from its suppliers to its retail outlets. Too many items in Heartland’s stores are out of stock, even
though many of these products are in the company’s distribution center warehouses.
Management believes that the new system would help Heartland Stores reduce the amount of
2006.
fie solution builds on the existing IT infrastructure at the Heartland Stores but requires the
purchase of additional server computers, PCs, database software, and networking technology,
along with new supply chain planning and execution software. fie solution also calls for new
radio-frequency identification technology to track items more easily as they move from suppliers to
distribution centers to retail outlets.
Chapter 14 Learning Track 1 5
continued
FIGURE 14-1 Costs and Benefits of the New Supply Chain Management System.
This spreadsheet analyzes the basic costs and benefits of implementing supply chain management
system enhancements for a midsized midwestern U.S. retailer. The costs for hardware, telecommunica-
tions, software, services, and personnel are analyzed over a six-year period.
THE PAYBACK METHOD
fie payback method is quite simple: It is a measure of the time required to pay back the initial
investment of a project. fie payback period is computed as follows:
Chapter 14 Learning Track 1 6
continued
In the case of Heartland Stores, it will take more than two years to pay back the initial invest-
ment. (Because cash ows are uneven, annual cash inows are summed until they equal the origi-
ACCOUNTING RATE OF RETURN ON INVESTMENT (ROI)
Firms make capital investments to earn a satisfactory rate of return. Determining a satisfactory
rate of return depends on the cost of borrowing money, but other factors can enter into the equa-
tion. Such factors include the historic rates of return expected by the firm. In the long run, the
FIGURE 14-2 Financial Models.
To determine the financial basis for a project, a series of financial models helps determine the return on
invested capital. These calculations include the payback period, the accounting rate of return on invest-
ment (ROI), the cost-benefit ratio, the net present value, the profitability index, and the internal rate of
return (IRR).
Chapter 14 Learning Track 1 7
continued
desired rate of return must equal or exceed the cost of capital in the marketplace. Otherwise, no
one will lend the firm money.
fie accounting rate of return on investment (ROI) calculates the rate of return from an investment
by adjusting the cash inows produced by the investment for depreciation. It gives an approxima-
tion of the accounting income earned by the project.
To find the ROI, first calculate the average net benefit. fie formula for the average net benefit is as
follows:
fiis net benefit is divided by the total initial investment to arrive at ROI. fie formula is as follows:
NET PRESENT VALUE
Evaluating a capital project requires that the cost of an investment (a cash outow usually in year
0) be compared with the net cash inows that occur many years later. But these two kinds of cash
ows are not directly comparable because of the time value of money. Money you have been prom-
ised to receive three, four, and five years from now is not worth as much as money received today.
fius, to compare the investment (made in today’s dollars) with future savings or earnings, you
need to discount the earnings to their present value and then calculate the net present value of
Chapter 14 Learning Track 1 8
continued
the investment. fie net present value is the amount of money an investment is worth, taking into
account its cost, earnings, and the time value of money. fie formula for net present value is this:
COST-BENEFIT RATIO
A simple method for calculating the returns from a capital expenditure is to calculate the cost-
benefit ratio, which is the ratio of benefits to costs. fie formula is
PROFITABILITY INDEX
One limitation of net present value is that it provides no measure of profitability. Neither does it
provide a way to rank order different possible investments. One simple solution is provided by the
profitability index. fie profitability index is calculated by dividing the present value of the total
cash inow from an investment by the initial cost of the investment. fie result can be used to
Chapter 14 Learning Track 1 9
INTERNAL RATE OF RETURN (IRR)
Internal rate of return (IRR) is defined as the rate of return or profit that an investment is expect-
RESULTS OF THE CAPITAL BUDGETING ANALYSIS
Using methods that take into account the time value of money, the Heartland Stores project is
cash-ow positive over the time period under consideration and returns more benefits than it
costs. Against this analysis, you might ask what other investments would be better from an e-
